Manjula Shaw, CFP®, CDFA®

“Tips from the Trenches” is a series of articles based on conversations with professionals who work with individuals facing or considering the prospect of divorce. Watch this space for conversations with professionals in family and collaborative law, such as forensic-certified public accountants, mediators, marriage counselors, family court judges, and valuation specialists. 

Manjula Shaw is a Certified Financial Planner (CFP®) and an Asst. Vice President at Tanglewood Legacy Advisors. As a Certified Divorce Financial Analyst (CDFA®), Manjula specializes in helping individuals navigate the financial complexities of late-stage divorce, including asset division, alimony, and child support. She is trained by Collaborative Divorce Texas as an independent, neutral financial expert committed to helping divorcing couples and families navigate competing and shared needs and develop solutions that best fit the parties and their children without court intervention.

After a recent talk to family lawyers and professionals in the divorce space on the topic of employer stock in retirement plans and tax-advantaged strategies that can be utilized, I received several requests to write a “Tips from the Trenches” article about it. Houston is home to many large and small businesses offering company stock in their defined contribution and profit-sharing plans. Strategies to minimize taxes when making a distribution from such plans are relevant to anyone going through a divorce.

Consider Net Unrealized Appreciation (NUA)

Couples typically focus on splitting account balances fairly when dividing retirement assets in a divorce. However, if employer stock is held in a 401(k), there’s a unique opportunity for tax advantages known as Net Unrealized Appreciation (NUA). NUA allows individuals to pay taxes only on the original cost basis of employer stock when withdrawn from a 401(k), instead of the full value. The appreciation can later be taxed at a more favorable long-term capital gains rate. This strategy can benefit both spouses in a divorce settlement involving employer stock. To successfully utilize NUA during a divorce, careful planning, a properly executed Qualified Domestic Relations Order (QDRO), and an understanding of applicable tax and distribution rules are essential. Only specific individuals can take advantage of this strategy, so it’s important to determine if employer stock is available in the retirement plan, if it has appreciated significantly, and whether a triggering event like divorce, reaching age 59 ½, or separation from service, disability (according to IRS code), or death—has occurred. The date of this event is called the trigger date.

What is NUA, and how does it work?

If you or your spouse worked for a company that offered stock in a 401(k) plan, that stock may have appreciated significantly. Taking a distribution results in paying ordinary income tax on the full value, and if you are under age 59 ½, an additional 10% penalty could be assessed, potentially leading to a large tax bill.

The image below illustrates what Net Unrealized Appreciation (NUA) is.

 

 

 

 

 

 

 

 

 

NUA is the difference between what you paid to purchase stock of company X in the 401(k) plan, called the “cost basis,” and what the stock is worth today, at the trigger date.

Instead of paying ordinary income tax on the whole amount when the stock is distributed, you can pay income tax only on the cost basis and pay long-term capital gains tax, usually at a much lower rate, on the rest when you sell the stock later.

The illustration below is a simple example of tax savings with an NUA election vs. without.

 

 

 

 

 

 

 

 

 

 

 

How can a divorce trigger eligibility for NUA?

When a couple divorces, retirement accounts like 401(k)s are often split between the two spouses. This is done through a legal document called a Qualified Domestic Relations Order (QDRO). A QDRO allows the ex-spouse- the “alternate payee”- to receive a share of the 401(k) without triggering early withdrawal penalties.

If the 401(k) includes employer stock, and the division is done correctly, both spouses can take advantage of the NUA strategy on their portion of the employer stock.

In next month’s article, stay tuned for common pitfalls and when the NUA strategy is not advisable.

Contact Manjula Shaw at mshaw@family-cfo.com if you have any questions.

Link to Manjula’s blog on all topics divorce is Blog – Family CFO

 

 

 

 

 

 

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